A few years ago I predicted the “Godzilla of all bond rallies” once QE II ended. Let’s revisit this prediction, and talk for a minute about a recent post a certain Mr. Roche concocted over at PragCap.
First, how did the prediction fare? Excellent! After I posted about a huge rally in bond prices (and the related fall in bond yields), the bond market rallied tremendously!
Here is the first chart I posted.
You can see how this chart is from early March, 2011. In it, I lay out how the bond market is likely to rally (and yields fall tremendously) once the Fed ended QE II.
I claimed this was from a “cash to clunkers” effect, where weak holders of bonds would want to sell to a strong buyer before that buyer went away.
You can see how the end of QE II did in fact spark a huge fall in yields, and a gigantic bond rally, when it ended. I don’t know what every bond trader in the world thinks, but I can tell you knowing a massive buyer will go away in 45 days puts a bit of pressure on you if you are thinking about selling at all.
So, how about QE III and the chart by Cullen? Cullen points out that QE III is having very little impact on commodity prices, and not much impact on equity prices either. Here is a very good chart he puts up to show just how little impact QE III is having on commodities. Here are a few interesting questions from CR:
“It all makes you wonder – is there a real fundamental driver behind QE or is it mostly psychological as I’ve been saying for a long time now? How could such a dramatic disconnect exist if there is so much more money in the system chasing fewer and fewer asset classes? ”
According to the conventional view of how QE works, QE III is pushing even more marginal money into a system, chasing after less total assets. This is the entire point of QE! At this point, commodities should be so hot they are melting upwards everyday. But QE III has turned out to be a bust for commodities. It hasn’t changed expectations much for government bonds either.
QE III is open ended. It’s all about the expectations channel. And it’s working a bit – housing is recovering. But do we want housing to recover? Is more houses really the best way to get our economy back on it’s feet?
Not only that, but we’re probably starting to get far above replacement value on homes again. In other words, building new houses will be extremely profitable. So profitable that there will probably soon be a glut of housing, which of course is not very good for housing prices.
Welcome to the boom/bust world of Godzilla in the bond market. Where QE goes on and forces up housing prices, until expectations stall and the fed is left holding worthless MBS and triggers a massive rally in government bonds. .
We’ve nationalized housing by following the advice of people who can only think in one color.